This blog is published by Weil’s Business Finance & Restructuring (BFR) department. The editorial board consists of BFR partners Ronit Berkovich and Stephen Youngman. Partners and associates from across the firm contribute to the blog, and Weil’s clients and fellow restructuring professionals are also welcome to contribute.
It’s been an interesting couple of weeks for bankruptcy at the United States Supreme Court with two bankruptcy-related decisions released in back-to-back weeks. Last week, the Supreme Court issued an important decision delineating the scope of section 546(e) of the Bankruptcy Code (discussed here for those who missed it). Then again, this week, on March 5, 2018, the Supreme Court issued a somewhat strange (in the authors’ view) decision involving “non-statutory insider” determinations in the Bankruptcy Code context. See U.S. Bank Nat’l Ass’n v. Village at Lakeridge, LLC, No. 15-1509, 2018 WL 1143822, at *1 (U.S. Mar. 5, 2018). The Lakeridge opinion purports to address only a narrow legal question: whether the Ninth Circuit Court of Appeals applied the proper standard of review in analyzing a bankruptcy court’s determination that a creditor was not a non-statutory insider. On that narrow question, the Court concluded that the Ninth Circuit appropriately reviewed the mixed question of law and fact on a “clearly erroneous” basis given the test articulated by the Ninth Circuit for determining non-statutory insider status. More interestingly, as highlighted by two concurrences, Lakeridge raises further questions as to how lower courts should evaluate whether a person qualifies as a non-statutory insider under the Bankruptcy Code, an issue that could have implications in various contexts in chapter 11 cases where insider status matters. These include plan voting (at issue here), fraudulent transfer and preference analyses, severance payments, and KERPs. And from a purely entertainment perspective, the facts of the case are somewhat fun and juicy.
As a quick primer, section 101(31) of the Bankruptcy Code provides specific examples of who qualifies as an “insider,” including directors, officers, and controlling persons of a debtor. However, courts have long held that it is not an exhaustive list, and that other unenumerated persons can still qualify as “non-statutory insiders.” Some courts have developed different tests to determine who qualifies as a non-statutory insider, although the Supreme Court has not yet endorsed any of those tests.
In this case, the debtor, Village at Lakeridge (the “Debtor”), had two major creditors, each separately classified under the Debtor’s chapter 11 plan: (i) U.S. Bank – a creditor owed over $10 million, and (ii) MBP Equity Partners – the Debtor’s sole owner and thus a statutory insider, (See 11 U.S.C. § 101(31)(B)(iii)), owed $2.76 million. The Debtor sought to cram down a plan over U.S. Bank’s objection, (See 11 U.S.C. § 1129(b)), but ran into the obstacle that any such plan still required the consent of an impaired class of claims and the vote of MBP, an insider, would not suffice. See 11 U.S.C. § 1129(a)(10).
The Debtor resolved this issue through a creative workaround. Kathleen Barlett, a member of MBP’s board and an officer of the Debtor, caused MBP to sell its claim to Robert Rabkin, Bartlett’s romantic partner, for $5,000 and Bartlett then voted the claim to accept the Debtor’s plan. Rabkin was clearly not a statutory insider, and despite an objection from U.S. Bank, the bankruptcy court concluded after an evidentiary hearing that he was not a non-statutory insider either. The bankruptcy court based its decision in part on its finding that Rabkin purchased the MBP claim as a speculative investment for which he performed adequate due diligence. The Ninth Circuit affirmed on appeal, first holding that a creditor qualifies as a non-statutory insider only if it meets two criteria: “(1) the closeness of its relationship with the debtor is comparable to that of the enumerated insider classifications in § 101(31), and (2) the relevant transaction is negotiated at less than arm’s length.” In re Village at Lakeridge, LLC, 814 F.3d 993, 1001 (9th Cir. 2016) (citing Anstine v. Carl Zeiss Meditec AG (In re U.S. Med., Inc.), 531 F.3d 1272, 1277 (10th Cir. 2008)). After finding that the bankruptcy court based its holding on the second prong of that test (i.e., that the transaction with Rabkin was at arm’s length), the Ninth Circuit affirmed the bankruptcy court’s decision under a clear error standard of review.
Supreme Court Opinion
The Supreme Court granted certiorari to answer a single, narrow issue: whether the Ninth Circuit was right to apply a clear error (rather than de novo) standard of review. In fact Justice Kagan, writing for Court, expressly acknowledged that the Court’s opinion “do[es] not address the correctness of the Ninth Circuit’s legal test; indeed we specifically rejected U.S. Bank’s request to include that question in our grant of certiorari.” Lakeridge, 2018 WL 1143822 at *4.
The Court began by offering a general legal principal that the proper standard of review for mixed questions of law and fact depends on which court is better positioned to answer such questions. See Lakeridge, 2018 WL 1143822 at *5 (citing Miller v. Fenton, 474 U.S. 104, 114 (1985)). Appellate courts are better suited to answering questions that may require expounding on the law, and in such instances a de novo standard of review should apply. In contrast, where mixed questions rely upon case-specific factual issues, trial court determinations deserve greater deference through a clear error standard of review. Because the bankruptcy court’s decision was based on a fact-intensive inquiry—whether Rabkin’s purchase of the MBP claim was an arm’s length transaction—the Court found that the Ninth Circuit was correct to apply a clear error standard of review.
The concurrences in the case (supported by four of the nine Justices) raise the question, admittedly not before the Court, of whether the Ninth Circuit’s test for non-statutory insider status is the correct approach.
Justice Kennedy wrote a brief concurrence to reiterate that the Court was not necessarily endorsing the Ninth Circuit’s test. He expressed some concern with the Ninth Circuit’s two-pronged inquiry, but suggested that Courts of Appeals should continue tinkering with different analyses to develop a better approach.
In a separate concurrence joined by Justices Kennedy, Thomas, and Gorsuch, Justice Sotomayor offered a more pointed perspective. In her concurrence, Justice Sotomayor took particular issue with the second prong of the Ninth Circuit’s test, noting that statutory insiders are unable to cleanse their votes by engaging in arm’s length transactions. Instead, she suggested that a better overall approach might be to look solely to a comparison between the characteristics of the alleged non-statutory insider and the statutory insiders to see whether they share sufficient commonalities. Alternatively, another acceptable approach might focus on a broader comparison that includes consideration of the circumstances surrounding any relevant transaction. Still, careful not to decide the appropriate test for determining whether a creditor qualifies as a non-statutory insider, Justice Sotomayor concluded by noting that a different standard of review might apply if the “correct” test was different from the one adopted by the Ninth Circuit.
One lesson here is that if your strategy is to sell your claim to avoid insider status, don’t sell it to someone with whom you have a romantic relationship. Not only might it defeat the goal of avoiding insider status (although in this case the parties escaped that consequence), but the details of your romantic relationship could also end up enshrined in the annals of the Supreme Court forever (a fate which the two lovebirds in this case did not escape).
On a more serious level, Lakeridge provides little binding guidance as to how lower courts should evaluate whether a creditor is a non-statutory insider under the Bankruptcy Code. Although it is clear that at least four Justices have reservations about the Ninth Circuit’s test, there is no consensus view as to a better approach, nor what standard of review would apply to such an approach. Lakeridge’s main takeaway seems to be that Courts of Appeals will likely continue experimenting until they land on a test that the Supreme Court is ready to endorse.
Yesterday, the United States Supreme Court, in Merit Management Group, LP v. FTI Consulting, Inc., Case No. 16-784, ruled that the “securities safe harbor” under section 546(e) of the Bankruptcy Code, 11 U.S.C. §§ 101-1532, does not shield transferees from liability simply because a particular transaction was routed through a financial intermediary—so-called “conduit transactions.”
Prior to Merit Management, a number of lower courts, including the United States Court of Appeals for the Second Circuit, had ruled that a transfer routed through a financial institution would, in effect, immunize the ultimate beneficiary of that transfer from avoidance on a constructive fraud theory. See, e.g., In re Quebecor World (USA) Inc., 719 F.3d 94, 100 (2d Cir. 2013).
In June 2016, the United States Court of Appeals for the Seventh Circuit rejected application of the 546(e) safe harbor in this manner in FTI Consulting Group, Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016).
The Supreme Court subsequently granted certiorari to resolve the split.
Like the Seventh Circuit, the Supreme Court rejected a broad-based application of 546(e).
Instead, the Supreme Court ruled that recipients of fraudulent transfers cannot, in effect, evade liability simply because a transfer was routed through a financial (“conduit”) institution.
In this analysis, the Supreme Court further rejected any application of section 546(e) that might involve a ‘step-by-step’ approach to limit liability. Rather, “[i]f a trustee properly identifies an avoidable transfer, . . . the court has no reason to examine the relevance of component parts when considering a limit to the avoiding power.” Merit Mgmt., slip op. at 14.
In other words, the ultimate beneficiary of an avoidable transfer will not be immune from liability under section 546(e) simply by using a financial intermediary.
The Supreme Court was careful to note, however, that the section 546(e) safe harbor should still shield financial institutions in their role as intermediaries in this process.
For example, “[i]f the transfer that the trustee seeks to avoid was made ‘by’ or ‘to’ a securities clearing agency . . . , then § 546(e) will bar avoidance, and it will do so without regard to whether the entity acted only as an intermediary.” Merit Mgmt., slip op. at 17.
As a result, Merit Management should not signal an increased risk profile for financial institutions operating as conduits for financial transactions (e.g., escrow agents, clearinghouses, etc.)—notwithstanding the narrow scope applied to section 546(e) elsewhere in that opinion.
That said, Merit Management raises the question as to how state law preemption will be applied in light of the Supreme Court’s now-narrow application of section 546(e).
In 2016, the Second Circuit ruled that a broad range of state-law creditor remedies, such as constructive fraudulent transfer claims, were preempted by section 546(e). See In re Tribune Co. Fraudulent Conveyance Litig., 818 F.3d 98, 118 (2d Cir. 2016).
This ruling has been appealed, with a request for certiorari pending before the Supreme Court.
More recently, lower courts within the Third Circuit have rejected the Second Circuit’s approach on section 546(e)’s preemptive effect. See, e.g., In re Physiotherapy Holdings, Inc., 2016 WL 3611831 (Bankr. D. Del. June 20, 2016).
It remains to be seen whether, if at all, Merit Management will affect the Supreme Court’s consideration of the preemption issue.
Weil’s London Business Finance and Restructuring team is excited to bring you our “What will 2018 hold?” bulletin, an overview of the legal and market outlook for the restructuring and insolvency market this year.
You can view our other recent articles on European Restructuring Watch, a site dedicated to presenting our views on developments in European restructuring.
We wish you and your family every success in 2018.
The United States Second Circuit has issued its ruling in the Momentive Performance Materials cases resolving three separate appeals by different groups of creditors of Judge Bricetti’s judgment in the United States District Court of the Southern District of New York, which affirmed Judge Drain’s confirmation of Momentive’s plan of reorganization. Significantly, the Second Circuit ruled that the Bankruptcy Court had erred in the process it used to calculate the “cramdown” interest rate applicable to replacement notes received by senior-lien noteholders under the plan. The Second Circuit remanded the cases to the Bankruptcy Court to assess whether an efficient market rate can be ascertained, and, if so, to apply that typically higher rate to the replacement notes. This Bankruptcy Blog piece will cover this aspect of the judgment, while upcoming blog posts will cover the Second Circuit’s rulings affirming the Bankruptcy Court and District Court in finding that the second-lien notes stand in priority to the subordinated notes, and that the senior-lien noteholders are not entitled to a make-whole premium. Our previous posts on these topics can be found here.
A so-called “deathtrap” can be an effective way to drive the confirmation of a plan of reorganization, particularly when paired with the Bankruptcy Code’s cramdown provisions. The concept can be simple: one scenario involves a debtor, or other plan sponsor, proposing a plan of reorganization that gives a class of secured creditors two choices. Option one – life: vote in favor of the plan and receive proposed treatment that the secured creditors can live with, but may not like. Option two – death: vote against the plan and get crammed – that is, receive the value of their secured claim in deferred cash payments over several years – often an unpalatable option for secured lenders who want their involvement in a given situation to end so that they can put their capital and time to more efficient use elsewhere. And if death wasn’t enough, a line of cases emanating from the Supreme Court’s decision in Till has led to the development of an additional coercive threat in some jurisdictions: these deferred cash payments (structured as secured takeback paper) can be designed with an interest rate that, rather than reflecting prevailing market rates, is a much lower national prime rate with a modest upward adjustment for risk – typically far lower than what lenders in the open market will command.
The Momentive debtors and their second-lien noteholders used this “deathtrap” technique in seeking to coerce their senior-lien noteholders to accept the proposed plan of reorganization: if the senior-lien noteholders voted for the proposed plan, they would receive payment in full, in cash, on confirmation of the plan, less a makewhole worth roughly $200 million to which they believed they were contractually entitled. Vote against the plan and receive takeback paper (replacement notes) equivalent to the secured claim (again, excluding the makewhole) to be paid out over several years, at a below-market (or Till) rate of interest. The difference was not insignificant – the senior-lien noteholders argued that the difference between the interest rate that their replacement notes received under Till compared to the 5-6+% that an efficient market would produce, amounted to as much as $150 million in lost interest over the life of the replacement notes.
Momentive’s senior-lien noteholders chose death and voted against the plan, but the Bankruptcy Court confirmed the Plan over their objection. And, as predicted by the senior-lien noteholders, their takeback paper got killed in the market, trading down to 93 cents immediately after being issued, and despite being senior in reorganized Momentive’s capital structure. Unsurprisingly, appeals ensued, which we covered extensively here.
The District Court for the Southern District of New York affirmed the Bankruptcy Court’s confirmation of Momentive’s plan of reorganization, finding (among other things) that it was bound to follow the Supreme Court’s decision in Till, which it interpreted as requiring a “formula” rate of interest to be applied to takeback paper (the national prime rate plus a 1-3% upward adjustment for risk). In so holding, the District Court declined to follow the interpretation of Till adopted in some other jurisdictions – most notably the Sixth Circuit – which have interpreted the Supreme Court’s decision in Till to allow Bankruptcy Courts to determine whether an efficient market exists for exit financing in chapter 11 bankruptcy cases. If an efficient market exists, a bankruptcy court may set the applicable interest rate for takeback paper at a market rate, and only if that inquiry is unsuccessful, may it adopt the Till “formula” rate.
Following the District Court’s ruling, it seemed likely that secured lenders in the Second Circuit – the heart of the financing world – would be stuck with a Till rate of interest on cramdown paper for the foreseeable future, handing debtors and plan sponsors a potent weapon for their strategic arsenal while increasing risk for distressed investors. Momentive’s senior-lien noteholders appealed the District Court’s decision to the Second Circuit, arguing that confirmation of Momentive’s plan of reorganization was not fair and equitable as required by section 1129(b) of the Bankruptcy Code (the “cramdown” provision), as the interest rate on their replacement notes was too low.
After oral argument in the Second Circuit in November 2016, the outcome seemed to some observers, on balance, more likely to result in the District Court’s decision being affirmed. Nevertheless, the Second Circuit took a different view in its recent ruling, finding that the Bankruptcy Court erred in the process that it used to calculate the interest rate applicable to the replacement notes received by the senior-lien noteholders. The Second Circuit remanded this issue to the Bankruptcy Court to assess whether an efficient market rate can be ascertained, and if so, to apply it to the replacement notes.
The Second Circuit’s ruling turned on whether a conclusive statement was made by the Supreme Court in Till as to whether the “formula” rate was generally required in chapter 11 cases. Finding that the Supreme Court did not make a conclusive statement to that effect, the Second Circuit determined to follow the Sixth Circuit in interpreting footnote 14 of the Till decision to mean that efficient market rates for cramdown loans cannot be ignored in chapter 11 cases, and that an interest rate that is apparently acceptable to sophisticated parties dealing at arms-length is preferable to a formula improvised by a court. Markets are “efficient” where, for example, “they offer a loan with a term, size, and collateral comparable to the forced loan contemplated under the cramdown plan”. Interestingly, the Momentive debtors had sourced proposals for these very loans in the event that the senior-lien noteholders voted to accept the plan, which would have entitled the senior-lien noteholders to a lump sum payment in cash on the effective date of the plan.
The Second Circuit affirmatively followed the Sixth Circuit’s decision in In re American HomePatient, Inc. and adopted the Sixth Circuit’s two-step approach as best aligning the Bankruptcy Code with relevant precedent. The two-step approach looks to determine if an efficient market for exit loans in chapter 11 proceedings exists, and to apply the market rate if it does, failing which the Till formula rate should be used.
The Momentive debtors objected to the senior-lien noteholders’ appeal from the District Court on the basis that the appeal was equitably moot – the plan of reorganization having been confirmed, there was, in common parlance, no way to unscramble the egg. The Second Circuit disagreed, finding that no other modifications to the plan would be required other than adjusting the interest rate on the replacement notes. This might require, at most, $32 million of additional annual payments by the debtors to their senior-lien noteholders over several years. With the Second Circuit finding that its ruling would be unlikely to unravel the plan, or threaten the debtors’ emergence, and recognizing that the senior-lien noteholders had presented expert testimony in Bankruptcy Court that an efficient market did exist for exit financing (and that the debtors had sought and received offers for lump sum exit financing at 5-6+% from third-party lenders in the event the senior-lien noteholders voted in favor of the plan), it seems that the Bankruptcy Court, now freed from Till, will find that an efficient market exists, and will adjust the interest rate on the replacement notes accordingly – a win for secured creditors. The Second Circuit arrived at no conclusion with regard to the outcome of this inquiry, so we will follow the upcoming proceedings with interest and watch for potential appeals to the Supreme Court.
The Second Circuit affirmed Momentive’s plan of reorganization in all other respects, affirming the Bankruptcy Court’s confirmation order and the District Court’s rulings affirming the second-lien notes’ priority over subordinated notes, and denying the senior-lien noteholders’ entitlement to the make-whole premium. Upcoming blog posts will cover both these issues.
Posted with permission from Norton Bankruptcy Law Adviser, April 2017 issue. Copyright (c) 2017 Thomson Reuters/West. For more information about this publication, please visit www.legalsolutions.thomsonreuters.com
Background: Professionals’ Fees in Chapter 11 cases
Chapter 11 reorganizations are a complex affair. They often require various professionals – attorneys, accountants, investment bankers, appraisers and other professionals – to represent and assist the trustee or debtor in possession in carrying out its duties under the Bankruptcy Code. Section 327 of the Bankruptcy Code provides that the trustee or debtor-in-possession may employ such professionals (as long as they are “disinterested persons” and do not hold or represent an interest adverse to the estate).
Two sections of the Bankruptcy Code deal with the compensation of such professionals. First, section 328(a) of the Bankruptcy Code provides that a trustee, with the court’s approval, may approve the retention of a professional “on any reasonable terms and conditions of employment, including on a retainer, on an hourly basis, on a fixed or percentage fee basis, or on a contingent fee basis.” Section 328(a) further states that “. . . the court may allow compensation different from the compensation provided under such terms and conditions after the conclusion of such employment, if such terms and conditions prove to have been improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions.” 11 U.S.C. § 328(a) (emphasis added). Section 330 of the Bankruptcy Code provides for a second (alternative) route for review of fees. Under section 330(a)(1), the Court may award the professionals retained by the debtor-in-possession (or trustee), “[r]easonable compensation for actual, necessary services” rendered by the professional, and “reimbursement for actual, necessary expenses”. 11 U.S.C. § Section 330(a)(1) (emphasis added). Furthermore, section 330(a)(3) clearly states that in determining the amount of reasonable compensation to be awarded to a professional, the court shall consider “the nature, the extent, and the value of such services” and shall take into account “all relevant factors”, including time spent, rates charged, whether services were necessary or beneficial at the time such services were rendered, whether the services were performed in a reasonable amount of time, and whether the compensation is reasonable based on customary compensation charged by comparably skilled practitioners in nonbankruptcy cases. 11 U.S.C. § Section 330(a)(3) (A-F).
In a recent bench decision by Judge Michael Wiles, in In Relativity Fashion, LLC, Ch. 11 Case No. 15-11989 (Bankr. S.D.N.Y. December 16, 2016) [ECF 2194], the Bankruptcy Court for the Southern District of New York discussed, in the context of investment bankers’ fee applications under section 328 of the Bankruptcy Code, the differences between these two sections and their underlying rationale. The Court also questioned the validity of the so-called “Blackstone Protocol”, an agreement developed over time that allows only the U.S. Trustee to raise objections to investment bankers’ fees under section 330 while all other parties are bound to the strict standard of section 328 of the Bankruptcy Code.
The Relativity Decision
(i) The Different Standards under Sections 328 and 330 Explained
Two investment banking firms – PJT Partners LP (formerly Blackstone Advisory Partners LP) and Houlihan Lokey Capital, Inc. – were retained in the Relativity case. Both firms’ retention agreements provided for a compensation structure that is relatively common to investment banker retentions, both within and outside bankruptcy. Both firms were to be paid monthly fees on an ongoing basis, plus a “transaction fee” to be paid if and when a transaction was consummated, so long as any other conditions in the agreement were met. Both firms filed fee applications and requested approval of “transaction fees” according to the retention agreements in the sums of $4.5-$5 million each. Two objections were filed. The objecting parties – a creditor and the fee examiner – argued that the Court should review the investment bankers’ fee applications for reasonableness using the standards set forth in section 330 of the Bankruptcy Code and not under section 328(a) of the Bankruptcy Code. They then argued that the applications do not satisfy the section 330 reasonableness requirements with respect to the proposed transaction fees.
The Court took the opportunity to comment on how the standards under section 328(a) differ from those under section 330 of the Bankruptcy Code. The Court noted that under section 328(a), once the fees are approved, they are payable unless the approved terms and conditions “prove to have been improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions.” 11 U.S.C. §328(a). Essentially, the Court noted, under section 328(a), reasonableness is judged in advance, and the issue is not revisited except in the very narrow circumstances permitted by the statute. On the other hand, the Court further noted that if the fees are not approved in advance under section 328(a), the fees are reviewed under the various reasonableness factors listed in section 330, which “calls for a review of reasonableness that, to some extent, is made after-the-fact, although the case law makes clear that the judgment is not supposed to be done completely with 20/20 hindsight.”
In an effort to clarify the underlying rationale for the different approach set forth in sections 328(a) and 330, the Court relied on a previous Fifth Circuit decision – Donaldson Lufkin & Jenrette Securities Corp. v. National Gypsum Co. (In re National Gypsum Co.), 123 F.3d 861 (5th Cir. 1997). The Fifth Circuit in National Gypsum explained that under section 330 of the Bankruptcy Code there is uncertainty as to the amount of fees that a professional will be awarded, since section 330 authorizes the Court to ascertain in retrospect what is the “reasonable compensation” based on the relevant factors of time, comparable costs, etc. The Fifth Circuit emphasized that under section 328 the Bankruptcy Code a professional may avoid that uncertainty by obtaining court approval of compensation agreed to with the trustee (or debtor-in-possession). Id, 862-863. Based on National Gypsum, the Court in Relativity reasoned that section 328(a) reflects the view that professionals are entitled to know what they are likely to be paid for their work: “If you agree to hire someone on a flat fee or percentage-fee basis, there should be some comfort that the compensation will be paid and that a court will not simply impose a new and different deal after all the work has been done.”
The Court in Relativity also found this case to be an appropriate opportunity to comment on investment bankers’ fees in general, and in particular on the subject of “transaction fees.” The Court noted that it is common practice in the investment banking industry to include a provision for payment of monthly fees as well as transaction fees in the retention agreement, and that investment bankers’ main compensation is through the “transaction fees” mechanism. Those fees usually are contingent on the consummation of a transaction so that they are not paid if a transaction does not occur, but apart from that condition, they often have no other requirements. The Court also noted that usually, but not always, the transaction fees are independent of the amount of time it takes to complete the transaction, the involvement of other people, etc. Finally, the Court noted that transaction fees are not unique to bankruptcy, that it has long been the practice of investment bankers to charge for their services in this exact same way outside of bankruptcy, and that there is a long line of cases in which New York courts have reviewed and enforced similar transaction fee provisions.
(ii) Questioning the validity of the “Blackstone Protocol”
The Court stated that the “Blackstone Protocol” was an arrangement that started in the Southern District of New York and represents a “negotiated truce” between investment banks and the Office of the U.S. Trustee for the Southern District of New York. Historically, the Court noted, the U.S. Trustee has been a much larger opponent of section 328(a) approvals than other parties have been, and to some extent, this was based on a philosophical view that retentions and fees should always be reviewed after-the-fact. The “Blackstone Protocol” says, in effect, that parties are bound by the section 328(a) standards, except for the U.S. Trustee, who has the right to object on Section 330 grounds. (The Court further noted that some investment bankers sought modified versions of the New York Blackstone Protocol when they were retained in Delaware. The primary focus of the limitation was an effort to obtain an agreement that the United States Trustee could object on section 330 grounds, but that the reasonableness of fees would not be based on hourly rate criteria.) In other words, agreements following the “Blackstone Protocol” generally say that the U.S. Trustee may object on all grounds set forth in section 330 of the Bankruptcy Code, while barring other parties from doing so.
The Court in Relativity noted that, in effect, the Blackstone Protocol creates a “hybrid situation” in which the court may apply the section 330 standards to an objection made by the U.S. Trustee, but otherwise must apply the section 328(a) standard. The court commented that “[f]rankly, it is not at all clear that Congress contemplated this kind of hybrid approach when it enacted Section 328(a)”. The Court cited a Second Circuit decision that expressly held that sections 328 and 330 of the Code are “mutually exclusive” and that the court may not conduct a section 330 inquiry if there has been a section 328 approval. Riker, Danzig, Scherer, Hyland & Perretti v. Official Committee of Unsecured Creditors (In re Smart World Technologies, LLC), 552 F.3d 228, 233 (2d Cir. 2009). Furthermore, the Court commented that “[e]xactly what it means for the United States Trustee to reserve rights to object under Section 330 is, frankly, not clear.” One possibility, the Court said, was that the Court should treat this reserved right as if no pre-approval of the transaction fees had been given at all, and as if there had been no prior determination as to the reasonableness of the fees or as to whether the fees were consistent with market standards. Another possibility was that the reservation of rights in the “Blackstone Protocol” means that the U.S. Trustee is not collaterally estopped on the question of whether the fee is market-based and can raise that issue later. The Court noted, however, that both these possibilities did not make sense and that both were unfair to the professionals and the other parties. The real aim of the arrangement, the Court concluded, was not to postpone the litigation of issues that could and should be litigated at the outset, but instead to provide greater flexibility to deal with changed circumstances that the parties think may be relevant but that might not be capable of being considered under the literal terms of section 328(a).
Ultimately, because the U.S. Trustee did not object to the fee applications in this case, the Court found that the question of the validity and scope of the “Blackstone Protocol” did not need to be addressed further. The Court went on to find that the objecting parties did not retain a right to object to the fees under the reasonableness standard of section 330. Accordingly, the Court applied section 328 of the Code, denied the objections and approved the investment bankers’ fees as requested.
While the Relativity Court’s comments regarding the “Blackstone Protocol” are dicta, the Court clearly conveyed its doubts regarding the validity and scope of this “Protocol”, and it is not unreasonable to think that these comments will be revisited by the same court or other Bankruptcy Courts in the future, under the right circumstances.
In Asarco, LLC v. Noranda Mining, Inc., the Tenth Circuit Court of Appeals held that representations made to the bankruptcy court that the Debtor’s settlement of environmental claims reflected only the Debtor’s share of the cleanup costs did not judicially estop the Debtor from brining a contribution claim against another potentially responsible party for those same costs.
Asarco, LLC (“Asarco”) is a mining smelting, and refining company. It filed for protection under Chapter 11 of the Bankruptcy Code in August 2005. After approximately $6.5 billion of Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA”) environmental claims were brought against the company in the chapter 11 case, Asarco agreed to a settlement of $1.79 billion with the Environmental Protection Agency (“EPA”) to resolve the environmental claims at 52 sites in 19 states. At issue in the case is the settlement for one site in particular, namely, the Lower Silver Creek/Richardson Flat Site (the “Site”), which settled for $7.4 million for cleanup costs associated with the Site.
The bankruptcy court approved the global $1.79 billion settlement with the EPA on June 5, 2009 finding that it met the two required legal standards required for approval, namely that the settlement was “fair, equitable, and in the best interests of the estate” pursuant to Bankruptcy Rule 9019(a) and that it was “fair, reasonable, and consistent with CERCLA,” pursuant to CERCLA.
In June 2013, Asarco brought an action against Noranda Mining, Inc. (“Noranda”) under 113(f) of CERCLA, seeking contribution for the $8.7 million ($7.4 million principal plus $1.3 million in interest) the company paid to settle the claims for the Site. The United States District Court for the District of Utah granted summary judgment in favor of Noranda. The District Court held that Asarco was judicially estopped from pursuing its claim because of representations it made to a bankruptcy court concerning its settlement agreement for the Site. Asarco appealed to the Tenth Circuit.
Tenth Circuit’s Analysis
To meet the standards required to approve a settlement under Bankruptcy Rule 9019 and CERCLA, Asarco presented the bankruptcy court with evidence that the settlement agreements were fair and equitable, and that the $7.4 million settlement amount reflected only Asarco’s proportionate share of liability for the cleanup costs. The district court held that Asarco was judicially estopped from bringing the contribution claim because Asarco had represented to the bankruptcy estate that the settlement represented only Asarco’s proportionate share of liability for the Site. Noranda had argued that claiming contribution against Noranda amounted to evidence that the $7.4 million settlement amount constituted an overpayment, and that Asarco effectively concealed a multi-million dollar asset from its creditors and the bankruptcy court.
The three factors that typically inform a court’s decision to apply judicial estoppel are: (1) a party takes a position that is “clearly inconsistent” with its earlier position; (2) adopting the later position would create the impression that “either the first or the second court was misled,” and (3) allowing the party to change its position would give it “an unfair advantage or impose an unfair detriment on the opposing party if not estopped.”
The district court found that (1) Asarco told the bankruptcy court that its fair share of liability for the Site was $7.4 million; (2) Asarco then claimed that this amount actually represented more than its allocable share of costs (evidenced by the contribution claim against Noranda); and (3) it followed that the two statements were “clearly inconsistent.”
Noranda argued that the bankruptcy court could only have approved the settlement if it were correlated to Asarco’s comparative fault, and that it could not approve the settlement if Asarco was taking on the entirety of the potential liability. In dismissing this argument, the Tenth Circuit held that while a CERCLA settlement should be fair, reasonable, and roughly correlated with the responsible party’s comparative fault, this does not do away with the contribution provisions of the CERCLA. The Tenth Circuit reasoned that a settlement is not necessarily unfair if a settling party pays more than an amount equivalent to its comparative fault, because, otherwise, no party would settle until a mini-trial was held to determine its exact share of environmental liability and there would never be need for a contribution action by a settling party.
Acknowledging the tension between Bankruptcy Rule 9019 and CERCLA, the Tenth Circuit dismissed the notion that the bankruptcy court would err if it approved a settlement that might have been for more than Asarco’s exact share of environmental liability. The Tenth Circuit concluded that CERLCA allows a party to settle for an inexact amount and later seek contribution from other parties for any amounts it overpaid. Because doing so, without more, does not equate to pursuing inconsistent positions, the Tenth Circuit held that the district court’s conclusion was inconsistent with the nature of CERCLA claims and of Asarco’s underlying settlement.
This case highlights the potential contradiction of seeking approval of a CERCLA settlement with the bankruptcy court and subsequently seeking contribution from another party for the same claims. The Tenth Circuit demonstrates that this contradiction should not bar CERCLA contribution claims because it would disincentivize settlements and would render such contribution provisions superfluous.
In a recent decision by the United States Bankruptcy Court for the District of Delaware, In re Hercules Offshore, Inc., et al., Judge Kevin J. Carey confirmed Hercules Offshore’s plan over objections by the Equity Committee—including an objection to allegedly impermissible plan releases and exculpations.
Hercules Offshore filed a joint prepackaged chapter 11 plan in its “chapter 22 case” approximately seven months after confirmation of the chapter 11 plan in its previous chapter 11 case.
Central to the deal culminating in the plan was a settlement agreement with the first lien lenders—approved by a special committee of independent directors—that, among other things, transferred all of the debtors’ assets to a wind down entity, permitted a 100% recovery to the general unsecured claimants, subordinated the first lien lenders’ claims to provide $15 million guaranteed payment to common stockholders, and reduced the amount of the first lien lenders’ claim by $32.5 million. The plan also provided lenders, directors and officers, and other third parties with releases from claims held by the debtors and releasing parties.
Notwithstanding a mediation, the Official Committee of Equity Security Holders, the “Equity Committee,” pursued several objections at the confirmation hearing, including an objection to the plan releases and exculpation provisions regarding claims held by debtors and other third parties. The court overruled these objections. Although this case does not offer anything new or unusual, it is a good reminder that proper corporate formalities and substantial supporting evidence are important factors in obtaining approval of releases.
Section 1123(b)(3)(A) of the Bankruptcy Code permits a plan of reorganization to provide for a settlement of a debtor’s claims and include debtor releases. Courts have identified five factors for determining whether a debtor’s release of a non-debtor is appropriate under a plan: (1) an identity of interest between the debtor and non-debtor such that a suit against the non-debtor will deplete the estate’s resources; (2) a substantial contribution to the plan by the non-debtor; (3) the necessity of the release to the reorganization; (4) the overwhelming acceptance of the plan and release by the creditors and interest holders; and (5) the payment of all or substantially all of the claims of the creditors and interest holders under the plan. These five factors are not exclusive or conjunctive requirements, but form the foundation for a court’s analysis in addition to any other relevant factors to the particular case.
Directors and Officers Releases
The plan released the debtors’ claims against the debtors’ current and former officers and directors, in addition to other related professionals. The Equity Committee asserted that the estate may have colorable claims against the debtors’ directors and officers for “engineering” a liquidation and for a failure to exercise fiduciary duties. However, after completing a viability analysis of the purported claims, the court concluded that the Equity Committee offered little support for its contentions.
The court first evaluated the decision by a special committee of independent directors to approve the settlement agreements with the first lien lenders under the business judgment rule. The standard only requires that a court determine that the debtors exercised sound business judgment in deciding to accept a settlement integral to the proposed plan. The decision must be made in good faith, with the reasonable belief that such decision is in the best interests of the corporation. This standard is satisfied when a board makes a decision on an “informed basis,” using its independent business judgment and considering the advice of attorneys and financial advisors.
The special committee pursued this settlement once it determined that bids received from a prepetition marketing process would not provide recoveries to unsecured creditors and equity holders. The court determined that the special committee satisfied the business judgment standard through evidence of frequent meetings to consider the debtors’ options, a lengthy and comprehensive marketing process, and the use of retained professionals to consider competing bids.
The court also considered the Equity Committee’s assertion that the board of directors failed to comply with its fiduciary duties and exercise sound business judgment in reacting to alleged defaults on a credit agreement’s leverage covenants. The court focused on evidence that the board met regularly to discuss and monitor the company’s financial position and discuss the details and implications of a potential default, finding that the board properly exercised its fiduciary duties in pursuing the chapter 11 plan, the option it believed would preserve the value of the estates and maximize recovery for all stakeholders.
The court further considered each of these potential claims in light of terms in the company’s certificate of incorporation, which exculpated the company’s officers and directors from liability so long as that person acted in good faith and in the best interests of the corporation. The court found that no credible allegations supported claims that would be excepted from the exculpation provisions in the certificate of incorporation and further found that because of the exculpation provisions that the directors and officers were further insulated from any claims against them.
The plan also included releases by the debtors of certain lender parties in exchange for those parties’ agreement to compromise their claims and allow for other claimholders to recover under the plan. The Equity Committee stated that the debtors had colorable claims against the released lender parties. The court evaluated and quickly dismissed the viability of the first two alleged claims of equitable subordination and equitable disallowance.
The court gave a more thorough review of the claim that the released lenders breached the covenant of good faith and fair dealing by (1) asserting baseless events of default; (2) declining to extend a deadline in a credit agreement; and (3) forcing entry into a forbearance agreement. The court dismissed the Equity Committee’s argument that the covenant defaults, which the debtors acknowledged, were immaterial as there was no materiality requirement in the credit agreements. The court stated that an implied covenant of good faith and fair dealing is breached when a party acts in a manner that would deprive the other party of the right to receive the benefits of their agreement and, further noting, that no obligation may be implied that would be inconsistent with other terms of the contractual relationship. With respect to the deadline extension and entrance into a forbearance agreement, the court found that the released lender parties did not overstep any boundaries of their contractual rights and that no implied covenant was breached. Not surprisingly, the court noted that the lenders being “aggressive,” “vocal,” “persistent,” and even “annoying” does not equate to wrongful conduct.
“Paramount” to the court’s decision was the evidence produced by first lien lenders of the substantial value provided to Hercules Offshore in the settlement agreements in exchange for these releases which most significantly included a reduction of the lenders’ claims, payment of unsecured creditors, and payment to shareholders.
The court approved the debtors’ releases based on the substantial and credible evidence put forth by the debtors and on the five factor analysis, although it did not include detailed examination of each factor.
Third Party Releases
The plan also included consensual third party releases. The Equity Committee objected to the third party releases on the basis that, with respect to the equity holders, these releases were not consensual and did not satisfy the requirements for approval of a non-consensual third party release through a jurisdictional and solicitation procedures argument. The court approved these releases after the debtors revised the plan so that common stockholders, other than restructuring support parties, did not provide the releases.
Release and exculpation provisions are frequently used and heavily negotiated provisions in a plan of reorganization. Although they are a popular tool for debtors, a court’s thorough review of a plan’s releases and exculpations is not uncommon. Proponents of such plan provisions should make every effort throughout the plan process to establish a record of an informed decision-making process. Courts in the Third Circuit often review plan release and exculpation provisions closely when faced with an objection. Hercules Offshore highlights some of the scrutiny that release and exculpation provisions may receive, particularly with respect to alleged colorable claims by those objecting to them. Proponents of these provisions should be prepared to defend these plan provisions before a court in light of those potential claims.
Good news: structured dismissals have survived Supreme Court scrutiny. Bad news: dismissals may be harder to structure, given yesterday’s 6-2 decision overruling the Third Circuit in Jevic narrowing the context in which they can be approved. We now have guidance on whether or not structured dismissals must follow the Bankruptcy Code’s priority scheme. The short answer is that they must. In issuing a decision that requires absolute adherence to the absolute priority rule outside the context of a chapter 11 plan, the Supreme Court shifted leverage back to hold-out creditors, whose position in the priority scheme must be respected in any structured dismissal approved by a Bankruptcy Court.
There are three possible outcomes in a chapter 11 bankruptcy: first, the court can confirm a plan of reorganization or a plan of liquidation to govern the distribution of the estate’s value; second, the case may be converted to a chapter 7 liquidation; and third, a bankruptcy court may dismiss the case as a straight or a “structured” dismissal. A bankruptcy court-ordered dismissal ordinarily attempts to restore the prepetition financial status quo. Yet if perfect restoration proves difficult or impossible (which it almost always will be) or if certain parties wish to achieve other outcomes, the bankruptcy court may, “for cause,” alter the dismissal’s normal restorative consequences and order a dismissal with some additional technology built in (most commonly releases, retention of jurisdiction, claims reconciliation mechanisms, and potentially additional value to junior stakeholders who otherwise might not be entitled to it).
The Bankruptcy Code makes clear that distributions in chapter 7 liquidation must follow the priority distribution scheme. While chapter 11 has more flexibility than chapter 7 of the Bankruptcy Code when it comes to the priority of distributions, a bankruptcy court cannot confirm a chapter 11 plan that contains priority-violating distributions over the objection of an impaired creditor class. However, the Bankruptcy Code does not explicitly provide for what priority rules—if any—apply to the distribution of assets if a case is dismissed. Jevic addressed that gap.
Jevic Transportation skidded into bankruptcy after being purchased in a leveraged buyout. The company’s bankruptcy precipitated the filing of two lawsuits against it. In the first lawsuit, a group of the company’s truck drivers won a judgment against the company for its failure to provide proper notice of termination required under the WARN Act. This victory led to a priority wage claim that would entitle the drivers to payment ahead of Jevic’s general unsecured claimants. In the second case, a committee of unsecured creditors sued the sponsor that led the company’s LBO for fraudulent conveyance in connection with the transaction. That case was settled with an agreement that involved a structured dismissal of Jevic’s chapter 11 cases that proposed to distribute the estate’s assets to general unsecured creditors while skipping wage claims with a higher priority in the Bankruptcy Code’s distribution scheme.
The Bankruptcy Court for the District of Delaware approved the settlement agreement and dismissed the case, reasoning that because the possibility of recovery for the drivers was “remote at best,” the failure to follow ordinary priority rules did not bar approval. The District Court and the Court of Appeals for the Third Circuit subsequently affirmed. The Supreme Court reversed these decisions, and remanded the case for further consideration in light of its decision.
In ruling that the distribution scheme violated the Bankruptcy Code’s priority rules and was therefore improper, the Supreme Court first held that the drivers had Article III standing because a settlement that respected ordinary priorities was a reasonable possibility. As a result of the dismissal of Jevic’s bankruptcy cases, the truck drivers lost a chance to obtain a settlement that would respect their priorities, which could be redressed in a decision in their favor.
Then, given the “importance of the priority system,” the Supreme Court stated that it could not identify an “affirmative indication of intent” from the Bankruptcy Code necessary to conclude that Congress meant to make a major departure for the priority rules in the structured dismissal of a bankruptcy case. Instead, the Supreme Court found that the Bankruptcy Code was designed to protect reliance interests acquired in the bankruptcy, and not to make “general end-of-case distributions” that would be “flatly impermissible” in a chapter 11 plan or chapter 7 liquidation, as happened in Jevic.
The Supreme Court also distinguished Jevic from In re Iridium Operating LLC, 478 F. 3d 452 (2d Cir. 2007), where the Court of Appeals for the Second Circuit approved a distribution under a settlement agreement that violated ordinary priority rules. In that case, a structured dismissal was not involved, the distribution was only interim in nature, and it would be “difficult to employ the rule of priorities” because “the nature and extent of the estate and the claims against it [were] not yet fully resolved.” The Supreme Court also noted that there were cases like Iridium where courts had approved such interim distributions. However, in those cases, “significant Code-related objectives” were served, such as preserving the debtor as a going concern, making the disfavored creditors better off, promoting the possibility of a confirmable plan, and protecting reliance interests. The Supreme Court found none of these factors to be present in the current case.
Finally, the Supreme Court rejected the Third Circuit’s use of a “rare case” exception that would permit bankruptcy courts to disregard priority in structured dismissals for “sufficient reasons.” Reasoning that it would be difficult to give precise content to the concept of “sufficient reasons,” the Supreme Court noted a “rare case” carve-out would run the risk of turning the exception into a more general rule, introducing uncertainty with “potentially serious” consequences—for example, departure from the protections granted particular classes of creditors, changes in the bargaining power of different classes of creditors even in bankruptcies that do not end in structured dismissals, risks of collusion between senior secured creditors and general unsecured creditors to squeeze out priority unsecured creditors, and increased difficulty in achieving settlements.
The Jevic decision determined that the Bankruptcy Code’s priority rules, as applied in chapter 11 and chapter 7 cases, also apply to the distribution of assets in a structured dismissal. Bankruptcy courts cannot approve structured dismissals that offend the priority scheme in the Bankruptcy Code without the consent of affected creditors. As a result, debtors and creditors alike will be limited in their ability to explore creative options that could maximize estate value and pragmatically resolve issues in particular circumstances—for example, some cases best positioned for structured dismissals will nevertheless end up in liquidation. Players in restructurings will just need to, as they always have, live with the changing rules.
Another issue is how parties in bankruptcy proceedings will use Jevic outside the context of structured dismissal to argue for a literal reading of the requirements under the Bankruptcy Code, which could limit a bankruptcy court’s discretion in a wide range of issues unrelated to how a chapter 11 case will wind up. That is certainly something to look out for in the future. For now, while the Supreme Court made it clear it expressed no view about the legality of structured dismissals in general, structured dismissals that do not violate the absolute priority rule have survived the highest court’s scrutiny. This should put to rest industry fears that the “rapidly developing field” of structured dismissals, as described by Justice Thomas in his Jevic dissent, would itself be dismissed.
In today’s global economy, transfers and payments by U.S. companies occurring outside the United States are commonplace. At the same time the avoidance provisions of the Bankruptcy Code are an important remedy for recovery of transfers made without adequate consideration or fraudulently, or that preferred certain creditors. Do the avoidance provisions apply to a U.S. debtor’s foreign transactions? This question was once again taken up by the Southern District of New York Bankruptcy Court in In re Ampal–American Israel Corp. Judge Bernstein answers, in short—they don’t. Ampal–American is the most recent event in a developing saga in this Bankruptcy Court’s treatment of foreign transfers.
Debtor Ampal–American Israel Corporation was a New York holding corporation with its subsidiaries, management, offices, and books and records located in Israel. Creditor Goldfarb Seligman & Co. is an Israeli law firm with its sole office in Israel, and that provided services to the debtor in Israel. Within 90 days of the bankruptcy filing, Ampal–American directed a transfer from its account at an Israeli bank to Goldfarb’s account at the same bank. After the case was converted to chapter 7 the Trustee filed an avoidance action against Goldfarb to recover the payment. Goldfarb argued that the avoidance powers under the Bankruptcy Code do not apply to foreign transactions.
The prevailing view in the Southern District had been that the avoidance provisions do not apply to foreign transfers. A year ago, however, this blog covered In re Lyondell, a decision that seemed to go against that grain by holding that section 548 of the Bankruptcy Code could apply to foreign transfers. Now, with Judge Bernstein weighing in on the issue, the pendulum swings back in favor of presuming that foreign transactions are not subject to avoidance.
To resolve this issue, courts apply the “presumption against extraterritoriality”—a complicated name for the simple idea that a federal law is assumed not to apply outside of the United States unless Congress gives some clear reason that it should. Courts apply a two-step process: First, for a particular statute the court asks whether Congress has given a clear indication that it should apply outside the U.S. If so, the court applies the law regardless of how “extraterritorial” the conduct is. The second step asks whether the conduct at issue, despite its foreign aspects, is essentially domestic such that the statute may be applied anyway. Thus, courts engage in two inquiries: 1) a legal question about Congress’s intent as to a particular statute, and 2) a factual question as to where the conduct occurred. Accordingly, the key question in an avoidance action is determining whether the transfer is foreign or domestic.
Ampal–American disagreed with the approach in Lyondell as to the first question, and clarified it as to the second. As this blog noted last year, Lyondell found that Congress intended to have avoidance actions apply abroad because of the comprehensive nature of the Bankruptcy Code. This argument also holds sway in the Fourth Circuit under In re French but one that Judge Bernstein did not find persuasive here. The Court therefore held that avoidance provisions of the Bankruptcy Code do not apply extraterritorially.
As to the second inquiry, Ampal–American solidified the framework for determining whether the conduct was essentially foreign or domestic. The key fact is where the “initial transfer” occurred. Here, because the transfer of payment for Israeli services occurred entirely in Israel, the transfer was not domestic and therefore immune from avoidance actions. Ampal–American suggests several relevant factors: the locations of the parties directing and receiving the transfer, where the services or goods were provided, and the location of the banks making the transfer. Here, all were in Israel, making the non-domestic determination an easy one. It remains to be seen, however, whether one of these factors carries disproportionate or even dispositive weight.
Under Ampal–American, it becomes slightly clearer how the Southern District of New York deals with avoidance of foreign transactions going forward. Further, if Lyondell was an outlier at the time it was decided, it appears to be even more of one now. The upshot is that parties can have greater confidence that purely foreign transactions would likely escape avoidance actions in this district. But because a split between the Judges still exists, case assignment remains a major consideration on this issue. It remains to be seen whether companies with predominant or even significant foreign operations find the uncertainty or the law in this venue to be too unfavorable, and instead tilt towards filing elsewhere—in the Fourth Circuit, for example, where the French reasoning remains persuasive.
The presumption against extraterritoriality has been a topic of increasing interest, and one to keep an eye on. This blog as well as others have explored the issue in the past year. The issue of foreign transactions and the avoidance provisions are sure to get more attention as companies become increasingly globalized. We’ll keep readers posted.
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